3. What Is Inventory? (contd.)
One of the most expensive assets of a
company
The objective of inventory management is to
strike a balance between inventory investment
and customer service
A firm can never achieve a low-cost strategy
without good inventory management
4. Functions Of Inventory
To “de-couple” or separate various parts of
the production process
To provide a stock of goods that will provide
a selection for customers
To take advantage of quantity discounts
To hedge against inflation and upward price
changes
5. Types Of Inventory
Raw material
Work-in-process
Maintenance / repair / operating supplies
Finished goods
7. Disadvantages Of Inventory
Higher costs
– Item cost (if purchased)
– Ordering (or setup) cost
Costs of forms, clerks’ wages etc.
– Holding (or carrying) cost
Building lease, insurance, taxes etc.
Risk of deterioration or obsolescence
Hides production problems
• Yield / scrap variations
• Unscheduled downtime
Total cost = 20% - 40% of inventory value/yr
8. Pressures On Inventory
Pressure for lower inventory
• Inventory investment
• Inventory holding cost
Pressure for higher inventory
• Customer service
• Other costs related to inventory
9. Inventory Management
ABC Analysis: Divides on-hand inventory into
three classes on the basis of annual dollar
volume – A, B, and C
• $ volume = Annual demand x Unit cost
Policies based on ABC analysis
• Develop class A suppliers more
• Maintain tighter physical control of A items
• Forecast A items more carefully
10. ABC Analysis (contd.)
% of Inventory Items
0
20
40
60
80
100
0 50 100
% Annual $ Usage
A
B
C
Class % $ Vol % Items
A 80 15
B 15 30
C 5 55
11. Independent vs. Dependent Demand
Independent Demand: demand for an item is
independent of demand for any other item
• Demand for refrigerators and demand for mobile phones
Dependent Demand: demand for an item is
dependent upon the demand for some other item
• Demand for refrigerators and demand for refrigerator
compressors
12. Inventory Costs
Holding cost - associated with holding or
“carrying” inventory over time
Ordering cost - associated with costs of placing
order and receiving goods
Setup cost – costs incurred to prepare a
machine or process for fulfilling an order
14. Inventory Holding Costs
(Approximate Ranges)
Category
Housing costs (building rent,
depreciation, operating cost, taxes,
insurance)
Material handling costs (equipment,
lease or depreciation, power,
operating cost)
Labor cost from extra handling
Investment costs (borrowing costs,
taxes, and insurance on inventory)
Pilferage, scrap, and obsolescence
Overall carrying cost
Cost as a
% of Inventory Value
6%
(3 - 10%)
3%
(1 - 3.5%)
3%
(3 - 5%)
11%
(6 - 24%)
3%
(2 - 5%)
26%
15. More units must be stored if more are ordered
Purchase Order
Description Qty.
Microwave 1
Order quantity
Purchase Order
Description Qty.
Microwave 1000
Order quantity
Why Holding Costs Increase?
17. Cost is spread over more units
Example: You need 1000 microwave ovens
Purchase Order
Description Qty.
Microwave 1
Purchase Order
Description Qty.
Microwave 1
Purchase Order
Description Qty.
Microwave 1
Purchase Order
Description Qty.
Microwave 1
1 Order (Postage $ 0.33) 1000 Orders (Postage $330)
Order quantity
Purchase Order
Description Qty.
Microwave 1000
How Can Order Costs Be Decreased?
20. EOQ Model
Objective: Minimize cost (ordering cost +
holding cost)
Assumptions:
• Known, constant and independent demand
• Known and constant lead time
• Instantaneous receipt of material
• No quantity discounts
• Setup and holding costs are the only variable
costs
• No stock-outs
21. Inventory Usage Over Time
Time
Inventory
Level
Average
Cycle
Inventory
0
Q
Usage Rate
Q
2
23. EOQ Model-When To Order?
Time
Inventory Level
Average
Cycle
Inventory
Q*
Reorder
Point
(ROP)
Lead Time
24. Developing EOQ Model Equations
Develop an expression for setup or ordering cost
Develop an expression for holding cost
Set setup cost equal to holding cost
Solve the equation for optimal order quantity
25. Developing Equations (contd.)
Q = Number of units per order
Q* = Optimum number of units per order (EOQ)
D = Annual demand in units
S = Setup/ordering cost for each order
H = Holding cost per unit per year
26. Developing Equations (contd.)
1. Annual setup cost = (Number of orders placed
per year) x (Setup/order
cost per order)
= (D/Q) (S)
2. Annual holding cost = (Average inventory level)
x (Holding cost per unit
per year)
= (Q/2) (H)
28. EOQ Example 1
Sharp Inc., marketer of painless hypodermic
needles to hospitals, wants to reduce its
inventory cost. Determine the optimum number
of hypodermic needles to obtain per order, given
that the annual demand is 1000 units; the setup
or ordering cost is $10 per order; and the holding
cost per unit per year is $ 0.50.
29. EOQ Model Equations (contd.)
Optimal Order Quantity
Expected Number of Orders
Expected Time Between Orders
Working Days / Year
=
= ×
= N =
D
Q*
Working Days / Year
= =
T
N
d
D
ROP d L
= =
× ×
Q*
D S
H
2
D = Demand per year
S = Setup (order) cost per order
H = Holding (carrying) cost
d = Demand per day
L = Lead time in days
30. EOQ Example 2
Sharp Inc. has a 250 day working year. Find
out the number of orders and the expected
time between orders
31. EOQ Equations (contd.)
Total annual cost = Setup (order) cost +
Holding cost
TC = (D/Q) S + (Q/2) H
Calculate the total annual cost for Sharp Inc.
32. Reorder Point-When To Order?
Inventory level at which order is placed
Assumptions:
• A firm will place an order when the inventory level for that
particular item reaches zero; and
• The firm will receive the ordered items immediately
ROP = (Demand per day) x (Lead time in days)
= d x L
where, d = Annual demand (D)/ No. of working
days
34. Example
An Apple distributor has a demand for 8000
iPods per year. The firm operates a 250-day
working year. On average, delivery of an
order takes 3 working days. Calculate the
reorder point.
35. Quantity Discount Model
Answers how much to order and when to order
Allows quantity discounts
• Reduced price when item is purchased in larger
quantities
• Other EOQ assumptions apply
Trade-off is between lower price and increased
holding cost
37. QDM (contd.)
Total Cost = Setup cost + Holding cost +
Product cost
TC = (D/Q) S + (Q/2) H + PD
where, Q = Quantity ordered
D = Annual demand (units)
S = Ordering/setup cost per order (or per setup)
P = Price per unit
H = Holding cost per unit per year
39. Steps in QDM
1. Calculate the optimal order quantity Q* using IP
instead of H because the holding cost will be
represented as a percent of unit price (P) of the
product
40. Steps (contd.)
2. Adjust upward those values of Q* that are
below the allowable discount range
3. Compute total cost for every Q* determined
in steps 1 & 2
4. Select the Q* that has the lowest total cost
41. Example
Wohl’s Discount Store stocks toy race cars.
Ordering cost is $ 49.00 per order, annual
demand is 5000 race cars, and inventory
carrying charge, as a percent of cost, I, is 20%,
or 0.2. What order quantity will minimize the total
inventory cost?
